On December 17, 2021, the Financial Stability Oversight Council (“FSOC”) – a collaborative body formed under the Dodd-Frank Act composed of state and federal regulators and tasked with identifying risks and responding to emerging threats to financial stability – released its 2021 Annual Report (the “Report”). In the Report, the FSOC offered wide-ranging insight into what it perceived to be various vulnerabilities in the financial system and related regulatory concerns on topics ranging from climate-related financial risks, the real estate market, certain financial structures, data challenges, and cybersecurity. Notably, the FSOC additionally dedicated a section of the Report on the specific risks digital assets pose to the financial system, specifically, those involving stablecoins.

Stablecoins are digital assets designed to maintain a stable value by pegging the digital asset to a national currency or another reference asset (i.e., a commodity like gold, silver, or oil). Using reference assets to stabilize price, stablecoins seek to become the alternative payment mechanism to bitcoin and other cryptocurrencies, and have also been used to facilitate trading and lending of other digital assets. However, the FSOC, taking a systemic, wide view, is not without concern.

The Report sees digital assets like stablecoins as presenting great payment innovations and efficiencies if reasonably regulated. Proponents note that a well-designed stablecoin may certainly be leveraged to enable faster and more efficient payment options, reaching a wider customer base.  At the same time, the FSOC sees potential systemic risk due to stablecoins’ lack of consistent risk-management standards and their operational complexity, all of which the FSOC advocates should be addressed by Congress and the appropriate financial regulators.  One of the FSOC’s concerns is that the reserve assets supporting a particular stablecoin may not be subject to rigorous audits. Thus, the reserves may not live up to issuer’s claims related to the quantity or quality of the coin’s collateral. If investors begin to doubt the credibility of the issuer’s claim that the stablecoins will maintain a stable store of value, then the stablecoin may be subject to widespread redemptions and asset liquidations. The Report points to other operational risks as well, including a failure to institute appropriate protections to stem illegal activity and maintain appropriate safeguards around reserve assets. According to the FSOC, these issues, and related cybersecurity concerns surrounding the collecting and storing of data, could undermine consumer confidence in stablecoins as a reliable source of value.

In addition, some stablecoins use algorithms to maintain their value. The Report asserts that this variety of stablecoin may be subject to volatility due to market pressures, operational failures, and other risks. The FSOC is concerned that a failure in this digital asset class (which the Report cites as exceeding $127 billion as of October 2021) may spread throughout digital asset exchanges and the financial system, resulting in a systemic shock.

Ultimately, The FSOC recommends that federal and state regulators begin to address some of these potential issues surrounding digital assets like stablecoins and come up with a comprehensive regulatory framework that promotes “responsible innovation and functional payments systems,” whatever the technology. The FSOC cited a November 2021 interagency report on stablecoins, which urged Congress to pass legislation to ensure that payment stablecoins (and related services such as custodial wallet providers) are subject to a “federal prudential framework on a consistent and comprehensive basis” that provides regulators flexibility to respond to future developments and adequately address risks across a variety of financial structures. Such legislative efforts should be designed accordingly to complement existing agencies’ work on market integrity, investor protection and illegal financial activities. At its best, a regulatory framework would bolster confidence in stablecoins, thereby increasing their potential upside. The FSOC stated that it would stand ready to consider steps available to it to address the various financial risks from stablecoins in the event Congress fails to act.

Proponents note that a well-designed stablecoin may certainly be leveraged to enable faster and more efficient payment options, reaching a wider customer base. However, businesses contemplating a strategy leveraging the budding technology should examine the risks posed by stablecoins before diving in. If, for any reason stated above, or otherwise, a stablecoin fails to perform according to expectations, then businesses and customers may be subject to credit risk, liquidity risk, operational risk, risks arising from improper or ineffective system governance, and settlement risk.

The FSOC is not the only entity concerned with regulating the asset class. For example, during 2021, the SEC, FinCEN, and the CFTC imposed notable settlements involving cryptocurrency trading platforms for operating without appropriate approvals. Also, Congress is starting its work. The House Financial Services Committee and the Senate Banking Committee held hearings in December to examine stablecoins, while the industry continues to engage with legislators and push for sensible consumer protections and light touch regulation as well as clarity regarding agency authority over digital assets and legal recognition of certain digital financial structures (e.g., decentralized  autonomous organizations (DAOs)).

Regulation is indubitably swirling in the area; however, it remains unclear the mechanism by which regulation and oversight will arise. Congress is actively debating cryptocurrency regulation, the industry itself is advancing self-regulatory proposals, the SEC seems poised to become more active in the area in 2022 and other agencies are gearing up given the growing popularity of crypto and other digital assets within the financial system.  If the past two years are any indicator, 2022 will be an unpredictable year. The FSOC’s report assures markets and investors of one thing, however: stablecoins are on regulators’ radar.